How To Get Monthly Income By Writing Covered Calls In Your IRA

Includes: MSFT
by: Rookie IRA Investor

Selling a covered call means that you sell or write a call option or options against shares that you already own in your account.

What is a call option?

When you buy a call, it gives you the right (but not the obligation) to buy a specific stock at a specific price per share within a specific time frame. A good way to remember this is: you have the right to "call" the stock away from somebody.

If you sell a call, you have the obligation to sell the stock at a specific price per share within a specific time frame - that's only if the call buyer decides to invoke their right to buy the stock at that price. [From The Options Playbook by Brian Overby.]

You cannot sell naked short calls (as uncovered calls are known) in an IRA account, because that would expose you to theoretically unlimited loss, but since you already own the stock it is guaranteed that you will be able to deliver the stock should the strike price be exceeded and the stock called away by your caller.

One option represents 100 shares, so you need a minimum of 100 shares, or a multiple of 100 shares to sell a covered call. Fortunately, you already own the underlying stock, so your potential obligation is covered - hence this strategy's name, covered call writing.

Why write covered calls?

Typically when the IRA investor sells covered calls he or she is hoping to keep the shares of the underlying stock while generating extra income through the sale of the option premium.

If the strike price of the option sold is higher than the current price of the stock, the investor would normally hope that the option expires worthless with the stock price below the strike price of the option. In this case the investor will keep the premium received as income.

Let's see how this could work with an example.

Let's say we own 1,000 shares of Microsoft Corporation (NASDAQ:MSFT) and we want to see what covered call we could sell, so we look up the options table for the current period.

Here we see that the bid price for the May 19th $33 call is 15 cents.

Since we own 1,000 shares, we can sell 10 calls, 1 call for each 100 shares, for a total premium of $150. This represents about 1/2% of the value of our stock, so if we sold this each month, that would come to 6% per year. But wait, we are going to have some brokerage transactions costs to take into account to open and close the position, and if you are not with a deep discount brokerage, the trade is hardly worth its while at all.

But hold on! Let's revisit the options table.

Supposing we sell the May 19th $32 call? This time we get three times as much money, 46 cents instead of 15 cents, so the sale reaps $460 or 1 1/2% or 18% if annualized. But wait (again). We are only going to collect that premium if the stock fails to gain 2 cents by May options expiration, and if the stock goes over $32, we will have our stock called away.

Does that matter? I say no, but opinions may differ.

Perhaps we would lose the next quarterly ex-dividend date due in mid June. But on the other hand, the 1 1/2% of the value of the stock we would receive for the sale of the option premium is worth two quarterly dividend payments, and if the stock were called away, we could sell an at-the-money put for another 1 1/2% to try to get our shares back again.

Another objection might be that we would stand to lose some upside movement of the stock. If the stock moves to $33 on options expiration, we will only have realized 46 cents of the $1.02 gain. This is true, but it is counterbalanced somewhat by the fact that if the stock corrects to $31 on options expiration, the current value of our 1,000 share position will only be down by $520 instead of $980, so we get 1 1/2% of downside protection.

The really important point to notice here is that in an IRA having the stock called away does not trigger a taxable event, so is much less of an inconvenience than it would be in a taxable or margin account, and that if the stock is called away, we can aggressively sell puts to get it back.

The biggest danger is that we might miss out on a sharp movement of the stock upwards, so really we are trading a theoretically possible capital gain for income right now. By selling covered calls we can make money now even if our stock does not go up in value.

Ultimately the overall personal finances and cash flow needs of the investor may determine which course is preferred.

Disclosure: I am long MSFT.

Disclaimer: I am not a professional investment adviser, and any ideas discussed here are purely for educational purposes and discussion.

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